CFM52530 - Derivative contracts: embedded derivatives: tax treatment under S616

CTA09/S616

This guidance is relevant to cases where the accounting standards applied result in the separation of an embedded derivative. For details of the accounting treatment for embedded derivatives and hybrid debt see CFM25020.

When S616 applies and what it does

S616 will apply to a derivative embedded in a contract other than a loan relationship (in other words, where the company is party to the relevant contract under S586) provided three further statutory conditions are met.

Conditions for application of s616

For S616 to apply:

• the embedded future, option or contract for differences must pass the ‘main accounting test’ ({CFM50200+}) - it must be treated as a derivative for accounting purposes;
• the embedded derivative must not be an interest rate contract to which regulation 9 of the Disregard Regulations applies (CFM57290);
• CTA09/S592 (CFM52580) must not apply to the contract; and
• the company must not have elected out of S616 or, if it is has made an election, the embedded derivative is one to which the election does not apply (CFM52560).

Actual accounting treatment normally overridden for tax purposes

Where all these conditions are satisfied, the contract is treated for all purposes of the Corporation Tax Acts as though the embedded derivative were closely related to the host contract, and was not separated out. Furthermore, it is treated as though fair value accounting were not used in relation to it.

This means that if, for example, the contract as a whole is a trading item, the trading profits will be computed on the basis of this deemed accounting, rather than the actual accounting. Debits or credits that arise on the derivative contract are not brought into account. CFM52540 gives an example.